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My Hedge Fund Gambit

I am in the process of starting a hedge fund, and I'm trying to persuade the 31 clients whose assets I manage via separate accounts to sign on.

Some clients, especially those I've served well for many years, have reacted with varying degrees of horror. They're certain that when I become a hedgie, I will, almost by definition, go bonkers and lay waste to their savings. They expect me
to go long on the Croatian kuna while shorting the Albanian lek, and to buy credit-default swaps on the subprime debt of Ukraine and lesser Slovenia. "But I'm a New Yorker," I say. "I barely know how to find Oklahoma."

The real reasons

Lawyers may talk about how wondrous the truth is as a defense, but it sure isn't working for me.
I tell clients I will not borrow to magnify returns nor use exotic investments. I tell them that I am starting a hedge fund because I want to earn an incentive fee on profits (I have a very good record) and because I'd like to place one trade for all my clients instead of 31 individual trades. Some clients hear that but seem to say, "Yeah, but what you really want to do is use 92-to-1 leverage and then move to Costa Rica."

Granted, a few clients aren't happy about paying higher fees (1.5% of assets per year, plus 10% of gains above the total return of Standard & Poor's 500-stock index). As my best friend and client, a lawyer, put it: "So let me get this straight: I'm supposed to pay more for the same service?"

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Well, uh, yeah, I guess. Clients were not thrilled about the higher fees, but it was clearly the fear of increased risk that unnerved some of them. Which is why I thought about starting a mutual fund instead. Then I quickly came to my senses. Mutual funds are more heavily regulated than plutonium producers. Managers of small funds, in particular, seem to spend most of their time on compliance matters, which is pretty much my notion of hell.

So a hedge fund it will be. But what, exactly, is a hedge fund? The best "definition" I've seen came from Federal Reserve governor Kevin Warsh, in testimony before a congressional committee this past summer: "The term hedge fund generally refers to a pooled investment vehicle that is privately organized, administered by a professional investment manager and not widely available to the public. The assets, investment strategies and risk profiles of funds that meet this broad definition are quite diverse. ... Some hedge funds are highly leveraged, while many use little or no leverage."

Spot on, I say, especially since I've told everyone that my fund will use no leverage. But when I say no leverage, I can just sense some clients thinking about all they've read in the Wall Street Journal and New York Times. Both papers routinely demonize hedge funds, focusing on those that have blown up or those with managers whose investment style could best be described as leveraged Ponzi.

Yes, hedge funds can implode, but so can mutual funds. Mutual funds just do so more slowly. In 2004, the Securities and Exchange Commission found that the high-profile Van Wagoner funds had misstated the value of some securities and barred Garrett Van Wagoner from serving as an officer or director of a mutual fund for seven years. Too little, too late. Investors who have held on to Van Wagoner Emerging Growth since March 2000 have lost nearly 90% of their money.

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Spreading the blame

Granted, it's hard for a mutual fund to be a complete fraud, as the Bayou hedge fund turned
out to be. But thousands of mutual funds underperform the market year after year. I'm tired of seeing hedge funds get all the bad public relations.